Although commodities are falling down on the job as a portfolio diversifier in the rough-and-tumble markets, it would be a big mistake to give up on the asset class altogether.
Sure, the one-year correlation between the S&P 500 and the S&P GSCI commodities index stood at 80 on Sept. 30, significantly higher than the 10-year average correlation of 30. A correlation of 100 means that the two indexes are moving in perfect unison.
But the marriage won't last. Indeed, over the long term, commodities and equities likely will revert to historical correlations.
“Once the markets start to regain their footing, and once we're making more strategic long-term decisions, the fundamentals of commodities should return to historical correlation levels,” said Abraham Bailin, an analyst at Morningstar Inc.
In the meantime, as the financial markets slog through a steady diet of risk-on/risk-off mood swings, investors may have to learn to be happy with what little diversification they can get from commodities.
“The correlation is clearly closer, but it still qualifies as diversification,” said Bill Belden, managing director and head of product development at Guggenheim Partners LLC.
It is almost ironic that the main reason commodities are behaving more like equities is the fact that commodities have become more popular as an asset class in recent years. Investors have glommed onto commodities as a way to insulate themselves from the travails of the equities markets.
As of Sept. 30, there were 31 commodities mutual funds with a total of $46.8 billion in assets, up from 15 mutual funds with $23 billion at the end of 2009. On Sept. 30, there was $111.1 billion invested in 122 commodities ETFs, up from $73.5 billion in 88 ETFs at the end of 2009.
“I think of what's happening with commodity and equity correlations the same way I think of what happened with emerging- and development-market correlations,” said K. Geert Rouwenhorst, professor of finance at the Yale School of Management. “As money started going into emerging-market investments that weren't correlated to the developed markets, the emerging markets became more correlated.”
That said, “we still believe in spreading our money around between emerging and developed markets, because as long as the correlation is not at [100], there are diversification benefits,” Mr. Rouwenhorst said.
Mr. Bailin described the increased access to commodities through packaged products such as mutual funds and exchange-traded funds as the “financialization of an asset class.”
“It is almost intuitive,” he said. “Without easy access, asset classes cannot easily be correlated.”
Thus, as the financial services industry rolls out more ways to access commodities, it may be worth considering less direct forms of commodities exposure, such as owning related companies.
For example, in addition to owning United States Oil Fund LP Ticker:(USO) — an ETF designed to track the spot price of West Texas Intermediate light, sweet crude oil — a financial adviser might want to add some shares of Exxon Mobil Corp. Ticker:(XOM) to their client's portfolio.
Year-to-date through Oct. 24, shares of Exxon, as a diversified explorer and producer of energy-related products, had gained 11.6%, compared with United States Oil's 9.3% decline.
Of course, that's just one example of diversification within the commodities space.
Another way to achieve more diversification is to use a commodities fund that invests both long and short.
“It's not clear to us that long-only commodities add consistent performance to a portfolio, and it's not even a genuine asset class,” said Ajay Dravid, who manages the long/short Equinox Commodity Strategy Fund Ticker:(EQCAX) for Equinox Fund Management LLC, a $1.4 billion asset management firm.
In order to use commodities as a portfolio diversification tool, the Equinox strategy tracks the SGI Smart Market Neutral Commodities Index, which automatically sells short every long commodity futures contract represented in the S&P GSCI commodities index.
Those short positions are designed to reduce the negative effects of contango, a technical condition unique to commodities in which expiring contracts are cheaper than the long-term contracts that must be purchased to maintain exposure to certain commodity classes.
Contango and its opposite condition, known as “backwardation,” are constant realities in commodities investing. Futures contracts are the only practical way to invest in most commodities.
The long side of the Equinox fund is separated into three categories based on the characteristics of each commodity.
The fund is up just 1.3% from the start of the year, but it has done so with just 20% of the volatility of the S&P 500, which is down less than 1% so far this year.
Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com
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